A Strong ETF Option to Hedge Short-Term Inflation

While still muted, inflation does pose a detriment to fixed-income portfolios, and with the inflationary outlook rising, bond ETF investors should begin thinking about a way to hedge against the negative effects of inflation.

Inflation that averages the Federal Reserve’s 2% target would diminish the dollar’s buying power to $0.67 after 20 years, writes Phillip Yoo for Morningstar.

Nevertheless, investors have a way to maintain their purchasing power through Treasury Inflation-Protected Securities, or TIPS. Unlike traditional debt securities, the principal of TIPS will move in tandem with inflation, rising with inflation or falling with deflation.

TIPS provide a direct hedge against inflation. The debt securities’ principal is adjusted to reflect changes in the Consumer Price Index, which allows investors to preserve their purchasing power. This index measures the price level for a market basket of goods and services that urban consumers would typically acquire, including food, housing, apparel, transportation, medical care, recreation, education, and communication. TIPS would apply a fixed rate to the adjusted principal, which changes the semiannual coupon that investors receive, rising with inflation and falling with deflation.

These debt securities are issued and backed by the full faith and credit of the U.S. government, so more conservative investors should feel safe knowing the bonds have minimal credit risk.